The Tax Cuts and Jobs Act passed in December 2017 created Internal Revenue Code (“IRC”) §164(b)(6), which limits the annual deduction for state and local taxes to $10,000. This prompted several states with higher individual income tax rates to introduce ways for constituents to counterbalance the impact of the limitation, including one alternative that taps into government-sponsored programs that generate state tax credits to offset an individual’s state and local liability.
The Department of the Treasury and the IRS have issued additional guidance on this matter in the past year, including proposed regulations to clarify whether state programs generating state tax credits correctly apply the IRC and Treasury Regulations as intended. After publication of the proposed regulations, on August 27, the agencies received a number of inquiries from taxpayers and other stakeholders regarding the application of the proposed regulations to business entities that make payments to charitable organizations described in IRC §170(c).
To address the matter, the IRS has since issued Revenue Procedure 2019-12, which clarifies that certain businesses (C corporations and pass-through entities) that contribute to charitable funds or certain government organizations in exchange for the receipt of state credits, can claim such contributions from federal taxable income as a business deduction without a corresponding reduction in the amount of the expense if certain safe harbor provisions are met.
Safe Harbor for C corporations – if a C corporation engaged in a trade or business makes a payment to an organization described in IRC §170(c), and receives or expects to receive a tax credit that reduces a state or local tax imposed on the C corporation, such payment is treated as meeting the requirements of an ordinary and necessary business expense for purposes of IRC §162(a) to the extent of the credit received or expected to received.
Safe Harbor for Pass-Through Entities – the safe harbor applies to all pass-through entities except single-member limited liability companies disregarded for federal income tax purposes. If the entity is subject to state and local tax, other than state or local income tax, while carrying on its trade or business, the pass-through entity may treat such payment as meeting the requirements of IRC §162(a) to the extent of the credit received or expected to be received. Otherwise, the deductibility of the payment must be determined at the level of the individual owners and subject to the $10,000 limitation of IRC §164(b)(6).
The safe harbor tests are effective January 1, 2018.